Related Quotes

Company Profile

“But a focus on austerity alone, without a parallel program of structural reform, risks undermining growth, scaring away investors and ultimately being rejected by voters."

The defeat of
Mario Monti
in the Italian elections, he says, demonstrates how fiscal discipline can backfire.

“His government met its immediate challenges to shrink fiscal deficits and reduce government bond yields. But it did so largely through raising revenues."

Monti failed to secure even the grudging support of the electorate. The result was the return of
Silvio Berlusconi
and Italy’s traditional political instability.

Italy and the other crisis economies are reforming their dysfunctional economies, and the pace of reform has accelerated. But reform has taken second place to the more urgent task of budget repair, and there is much more that could be done – and might be done if the adjustment costs of reform were not being magnified by fiscal policy.

It is easy to see why governments have emphasised fiscal austerity over structural reform. Fiscal austerity can be implemented more quickly and offers the prospect of a quick payoff in the form of lower interest rates on government debt.

Unlike swinging tax increases, reform of labour and product markets must be telegraphed in advance, and is certain to generate fierce political resistance. Building support for the reforms requires months of campaigning, and that is all for a growth dividend that typically is predicted by economists to arrive sometime in the medium to longer term.

In the scramble to close the gap between the cost of government borrowing and the economy’s growth rate, it is no wonder that politicians prefer quick action to reduce the interest rate over slower action to increase the economy’s growth rate.

However, the Italian experience shows that the advantages of fiscal austerity over structural reform are largely illusory.

Monti could rush tax increases into place, but he could not sustain them politically. The apparent advantage of fiscal austerity – the element of surprise – was its fatal weakness. And the Monti government’s experience is likely to undermine the usefulness of austerity programs in the other crisis states.

In the short run, fiscal austerity usually undermines economic growth which actually makes it harder to reduce the ratio of public debt to gross domestic product.

Research by economists at the International Monetary Fund has shown that the impact of fiscal tightening on economic growth is greater in recessions, when there is an increase in the proportion of cash-constrained households and businesses that have no choice but to cut spending in the face of increased taxes or reduced government payments.

Unfortunately, countries with short-term interest rates near zero also are less able to offset the effect of fiscal tightening with easier monetary policy. Nor, in a global slowdown, can they so easily look to export markets as an alternative source of demand.

It is only when the austerity program is judged by the financial markets as sustainable that investors are willing to cut the risk premiums they demand on government borrowing.

But after Italy, convincing investors of the sustainability of government austerity programs will be harder.

Research also suggests that structural reform in Europe’s crisis economies will be more rewarding than previously thought. According to the IMF, empirical studies show that comprehensive and ambitious reforms in both product and labour markets would boost GDP levels by more than 10 per cent in most euro zone countries over a decade.

Structural reform that is suddenly foisted on an unsuspecting public may have no more chance of survival than the Monti government’s tax shock. But when the way is properly prepared, structural reform can stick.

Moreover, in contrast to fiscal austerity, the bigger and more wide-ranging the reform, the more sustainable it is likely to be. Wide-ranging reform increases the likelihood that people disadvantaged by one reform will gain from another.

Of course everyone knows that productivity-boosting reform is fundamental. Without it, the southern economies cannot stay in the euro.

But how can a government that is under the siege of a sovereign debt crisis possibly opt for the slower route of structural reform? Clearly the gains from reform would be greatly reduced if impatient financial markets ramped up interest rates.

However, no one is saying fiscal austerity is unnecessary – only that it should not be over-used at the expense of reform, as it has been in Europe. And Hildebrand is making an additional, critically important point: governments have misread the concerns of investors.

“Markets are not solely – or even particularly – fixated on quarter-by-quarter fiscal out-turns. Rather, investors require reassurance that debt and deficits will be sustainable in the medium term," he says.

“Near-term austerity measures alone are not necessarily the best way to satisfy them. A transparent and credible commitment to reform is likely to provide the market with more comfort."

If he is right, European politicians have more choices in dealing with the euro area’s sovereign debt crisis. The pressure created by Italy and Cyprus should motivate governments to explore them more seriously.